Warning from a Business Broker: Be Cautious with Seller Carry Notes on Full Standby

When buying a business, financing options play a crucial role in determining the deal's success. One such option, the seller carry note on full standby, can be extremely useful and has its place. However, it's important to ensure that it’s not being used to the buyer's disadvantage.

What is a Seller Carry Note on Full Standby?

A seller carry note on full standby is an agreement where the seller finances part of the purchase price. The payments on this note are deferred for a set period, often two years, during which no payments are required. This can help improve cash flow for the buyer in the short term.

Potential Risks

While this arrangement can be beneficial, I've noticed some sellers and brokers using it to inflate the business valuation. They play with the debt service ratio to make the deal look better on paper than it is in reality. Here’s why buyers should be cautious:

1. Debt Service Coverage Ratio (DSCR)

The debt service coverage ratio is a key metric lenders use to assess a business's ability to service its debt. A healthy DSCR indicates that the business generates enough income to cover its debt obligations. If a business does not meet a reasonable DSCR today, you're taking a significant risk assuming it will be able to in the future.

How a Full Standby Period Impacts SBA Loans

Let’s break down how the standby period of a seller note impacts the overall risk of an SBA loan:

1. Initial Cash Flow Relief

During the standby period, no payments are required on the seller note. This improves the business's cash flow, reducing immediate financial pressure on the borrower. For example, if a business generates $100,000 per year in cash flow and has $80,000 in debt service obligations, placing a $20,000 seller note on standby can temporarily relieve this pressure.

2. Deferred Risk

The risk is simply pushed to the end of the standby period. After 24 months, the borrower must begin making payments on the seller note. If the business's cash flow hasn’t improved sufficiently, this can lead to financial strain. Using our earlier example, if the business still generates $100,000 per year in cash flow after two years but now has $100,000 in debt service obligations, the situation becomes untenable.

3. Lender Confidence

The standby period can make lenders more confident in the borrower’s ability to manage initial cash flows. This can increase the likelihood of loan approval since the lender sees a buffer period where the immediate cash flow is not overly strained.

4. Long-term Risk

The overall risk to the SBA loan may increase after the standby period if the business cannot generate enough cash flow to cover both the SBA loan and the seller note payments. This deferred payment structure can create a false sense of security if the business's financial health does not improve as anticipated.

Practical Example with Math

Let's put this into numbers for a clearer understanding. Suppose you're buying a business for $500,000. The deal includes:

- An SBA loan of $400,000

- A seller carry note of $100,000 on full standby for 2 years

- Annual cash flow of the business is $120,000

In the first two years:

- You only need to service the SBA loan, assuming an annual debt service of $50,000.

- Your DSCR is $120,000 / $50,000 = 2.4, which is healthy.

After the standby period ends:

- You must now service both the SBA loan and the seller note, assuming the combined annual debt service is now $70,000.

- Your DSCR drops to $120,000 / $70,000 = 1.71, which might still be acceptable but leaves less room for error.

If the business's cash flow doesn’t grow:

- The DSCR might drop further, creating financial strain.

- Any unforeseen expenses or a dip in revenue could make it difficult to service the debt.

My concern is that a buyer might be tempted to push the debt down the road, hoping for future improvements that may not materialize. It's crucial to assess the business's current and projected cash flows realistically. Make sure the business can meet its debt obligations today, not just after a rosy future projection.

Always perform thorough due diligence and consult with financial advisors to understand the full implications of a seller carry note on full standby. This will help you make a well-informed decision and avoid potential pitfalls down the road.